The Circular-Flow Model of the Economy

Circular Flow Model

One of the main basic models taught in economics is the circular-flow model, which describes the flow of money and products throughout the economy in a very simplified way. The model represents all of the actors in an economy as either households or firms (companies), and it divides markets into two categories:

  • Markets for goods and services
  • Markets for factors of production (factor markets)

(Remember, a market is just a place where buyers and sellers come together to generate economic activity.) The model is illustrated by the diagram above.

Goods and Services Markets

Circular flow model

In goods and services markets, households buy finished products from firms that are looking to sell what they make. In this transaction, money flows from households to firms, and this is represented by the direction of the arrows on the lines labeled “$$$$” that are connected to the “Goods and Services Markets” box. (Note that money, by definition, flows from buyer to seller in all markets.)

On the other hand, finished products flow from firms to households in goods and services markets, and this is represented by the direction of the arrows on the “Finished product” lines. The fact that the arrows on the money lines and the arrows on the product lines go in opposite directions simply represents the fact that market participants always exchange money for other stuff.

Markets for the Factors of Production

Circular flow model

If markets for goods and services were the only markets available, firms would eventually have all of the money in an economy, households would have all of the finished products, and economic activity would stop. Luckily, goods and services markets don’t tell the whole story, and factor markets serve to complete the circular flow of money and resources.

The term “factors of production” refers to anything that is used by a firm in order to make a final product. Some examples of factors of production are labor (the work was done by people), capital (the machines used to makes products), land, and so on. Labor markets are the most commonly discussed form of a factor market, but it’s important to remember that factors of production can take many forms.

In factor markets, households and firms play different roles than they do in the markets for goods and services. When households provide (i.e. supply) labor to firms, they can be thought of as the sellers of their time or work product. (Technically, employees can more accurately be thought of as being rented rather than being sold, but this is usually an unnecessary distinction.) Therefore, the functions of households and firms are reversed in factor markets as compared to in goods and services markets. Households provide labor, capital, and other factors of production to firms, and this is represented by the direction of the arrows on the “Labor, capital, land, etc.” lines on the diagram above.

In the other side of the exchange, firms provide money to households as compensation for the use of factors of production, and this is represented by the direction of the arrows on the “SSSS” lines that connect to the “Factor Markets” box.

The Two Types of Markets Form a Closed Loop

Circular flow model

When factor markets are put together with goods and services markets, a closed loop for the flow of money is formed. As a result, continued economic activity is sustainable in the long run, since neither firms nor households are going to end up with all of the money. (It’s also worth noting that firms are owned by people, and people are parts of households, so the two entities are not quite as distinct as the model implies.)

The outer lines on the diagram (the lines labeled “Labor, capital, land, etc.” and “Finished product”) also form a closed loop, and this loop represents the fact that firms use factors of production to create finished products and households consume finished products in order to maintain their ability to provide factors of production.

Models Are Simplified Versions of Reality

Circular flow model

This model is simplified in a number of ways, most notably in that it represents a purely capitalistic economy with no role for government. One could, however, extend this model to incorporate government intervention by inserting government between the households, firms, and markets.

It’s interesting to note that there are four places where the government could be inserted into the model, and each point of intervention is realistic for some markets and not for others. (For example, an income tax could be represented by a government entity being inserted between households and factor markets, and a tax on a producer could be represented by inserting government between firms and goods and services markets.)

In general, the circular-flow model is useful because it informs the creation of the supply and demand model. When discussing the supply and demand for a good or service, it is appropriate for households to be on the demand side and firms to be on the supply side, but the opposite is true when modeling the supply and demand for labor or another factor of production.

Households Can Provide Things Other Than Labor

Circular flow model

One common question regarding this model is what it means for households to provide capital and other non-labor factors of production to firms. In this case, it’s important to remember that capital refers not only to physical machinery but also to the funds (sometimes called financial capital) that are used to buy the machinery used in production. These funds flow from households to firms every time people invest in companies via stocks, bonds, or other forms of investment. Households then get a return on their financial capital in the form of stock dividends, bond payments, and the like, just as households get a return on their labor in the form of wages.